Using the data in Example 19.1, calculate the rate of return in dollars to a U.S. investor holding the British bill if the year-end exchange rate is: 

(a) E₁ = $2.00/£; 

(b) E₁ = $2.20/£.

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EXAMPLE 19.1 Exchange Rate Risk Consider an investment in risk-free British government bills paying 10% annual interest in British pounds. While these U.K. bills would be the risk-free asset to a British investor, this is not the case for a U.S. investor. Suppose, for example, the current exchange rate is $2 per pound, and the U.S. investor starts with $20,000. That amount can be exchanged for £10,000 and invested at a riskless 10% rate in the United Kingdom to provide £11,000 in one year. What happens if the dollar-pound exchange rate varies over the year? Say that during the year, the pound depreciates relative to the dollar, so that by year-end only $1.80 is required to purchase £1. The £11,000 can be exchanged at the year-end exchange rate for only $19,800 (= £11,000 x $1.80/£), resulting in a loss of $200 relative to the initial $20,000 investment. Despite the positive 10% pound-denominated return, the dollar-denominated return is a neg- ative 1%.